Wednesday, July 4, 2012

A small manufacturing company has an equity multiplier of 2.5. All of the manufacturing company’s assets are financed by a bank with a combination of long-term debt and equity.

Calculate the company’s debt ratio using this accounting information?

Accounting Answer:

If company has an equity multiplier of 2.5, this means that the company has $2.5 of asset against every dollar of equity that is issued in the form of common stock.

The first step is to calculate the Equity Ratio of the company:

Formula of Equity Ratio is : 1/Equity Multiplier

Equity Ratio =1 / 2.5=0.40=40%

Therefore, if the company's assets are 40% financed by common equity, then the remaining 60% of assets are financed by debt, thus debt equity ratio will be 0.60 or 60%. That is the correct answer to the accounting problem.